Why the US may well need a recession, 2

A while ago I argued in this blog that the US might benefit from a recession, because it was highly unlikely that the fundamental adjustment required in the US economy – a substantial increase in the national saving rate – is achievable without a period of growth below potential. Others have made similar points, and not just the usual European suspects, with post-colonial chips on their shoulders and an excess of Schadenfreude whenever the US trips over a banana peel. In recent contributions to the FT, Chrystia Freeland (Canadian, I believe) and Ricardo Hausmann (Venezuelan, when last I met him) have also made the point that the US needs, or would benefit from, an early serious slowdown in economic activity/recession. As the proud owner of both a US and a UK passport (and the former owner of a Dutch passport), my motives are, of course, beyond suspicion.

No US economist working in the US whose views I have read or heard supports the idea that a recession might be what the US needs right now. I think part of the difference in perspective comes from the fact that Europeans and other non-Americans view the US as an open economy that for decades has been saving too little and has been living beyond its means by borrowing abroad. They believe that the external constraint on the US addiction to current consumption is likely to become binding soon and certain to become binding in due course. Americans still tend to do much of their thinking about the US economy as if it were either the entire world economy, or at any rate a closed economy with just a couple of large holes in it: one through which oil imports pour in and another through which US Treasury bills and bonds disappear, never to be seen again.

In fact the US is well on its way to becoming a semi-small open economy on the trade side (with some influence over its terms of trade) and a small open economy on the financial side. The US now accounts for about 30 per cent of world GDP at market exchange rates (less at PPP exchange rates).

In the financial field, the speed with which the euro is bridging the gap with the US dollar, once considered unassailable as an international reserve currency, has surprised even the greatest Euro optimists. With the US now the world’s largest external debtor nation, monetary policy in the US is increasingly constrained by international financial markets. The (to my mind) reckless interest rate cuts by the Fed risk spooking domestic and international holders of US dollar-denominated securities who have many alternative investment opportunities, both low risk sovereign debt instruments and higher-risk/higher-return investments in non-US equities, including those issued by emerging markets. The risk of a sharp sell-off of US dollar -denominated securities and an associated increase in long-term US dollar interest rates could easily turn the US slowdown into a recession, even a prolonged one. A US recession that would be mild with 10-year US Treasury bonds yielding 3.6 percent could become deep with 10-year US Treasury bonds at 6.6 percent.

But even if the US were a closed economy, I would still believe that the kind of sustained increase in the national saving rate – by at least six percent of GDP to give US citizens hope of a dignified retirement (rather more than the three percent of GDP increase in the national saving rate required to restore external sustainability for the US) – cannot in practice be achieved without passing through a material slowdown, and possibly a recession.

Higher saving means lower consumption or higher income without a commensurate increase in consumption. I am sufficiently Keynesian to believe that a planned reduction in consumption will cause a temporary slowdown in activity. The kind of supply-side miracle that would produce an increase in income without a matching increase in private and public consumption is hard to visualise for the US. China has managed just that during the past decade, but the US is hardly China.

For the past couple of decades, the US consumer has been saved from the consequences of his under-saving by wallet-expanding painless capital gains. Unfortunately these capital gains were to a significant extent bubble-born and these bubbles have imploded one after the other. After the tech bubble and bust and the housing boom and bust, I cannot see another asset bubble coming along in time to rescue the improvident US consumer.

Therefore, to restore a sustainable external balance and to accumulate the financial assets that will support a greying US population in the style it would like to and hopes and expects to be accustomed to, the US private and public sectors must save more. To get to a higher saving and wealth trajectory, the US economy will first have to pass through the valley of the shadow of deficient effective demand, rising excess capacity and growing unemployment. Postponing the necessary adjustment will just make the pain of the eventual unavoidable correction that much greater.

There are two ways to achieve a traverse to a higher saving and financial wealth trajectory without passing through a slump. The first would be for US investment demand to rise by the same amount as consumption demand falls. This, however, would mean that the external imbalance would not be corrected. An increase in domestic capital formation that matches the increase in planned national saving is therefore not part of a sustainable adjustment programme. In addition, it is not easy to see what would motivate such an increase in investment.

A significant increase in private fixed investment is unlikely, because there are now, at the margin, many more attractive investment opportunities in other parts of the world. The US economy labours increasingly under an inadequate and ageing stock of infrastructure capital. The education and skill levels of its labour force are no longer the best in the world. Even in the higher education sector, where the US still has virtually all of the world’s leading institutions, the overall picture is one of islands of excellence in a sea of mediocrity. Secondary education is typically and on average poor, as are numeracy skills and literacy standards. Immigration has helped keep up US skill levels and underpinned it meritocratic traditions. Post-9/11 immigration paranoia threatens that vital contribution to US economic dynamism. Meritocracy is mutating into plutocracy.

A major boost to infrastructure investment would be more than welcome to boost the supply-side of the economy. For external balance reasons it would, however, have to be financed by a further increase in public saving. Any US politician running on a programme of higher taxes or lower current spending to pay for better infrastructure would in all likelihood not get elected.

The second way for the US economy to achieve a lasting increase in the saving rate without a temporary slump, would be for net exports to rise by the same amount as planned saving. That’s possible but not likely. The decline in the nominal external value of the US dollar is certainly helping, but the shift of domestic resources from the non-traded sectors (including construction) to the traded sectors (both exporting and import-competing) is unlikely to be accomplished solely through relative price signals. Painful quantity adjustment, including idle labour and capital in the over-expanded non-traded sectors is likely to be necessary.

So I don’t understand why both Larry Summers and Martin Feldstein, who have for many years preached the need for America to save more, do a 180-degree turn whenever there are signs that a higher saving rate may actually be in the making, and recommend expansionary fiscal and monetary measures to prevent at all cost a decline in the level or even the growth rate of consumption. The American economy is broke. To fix it a slowdown is well-nigh inevitable and a recession is likely to be necessary.

But the ostriches in the Fed, the White House and the Capitol are unmoved by such concepts as unsustainability. The prevailing ethos is myopic at best: let’s just put out this immediate fire, because it threatens today’s comfort level. Postponing adjustment raises the expected cost of the eventual adjustment, but that is then and this is now. Also, something may turn up. Santa Claus could exist after all. We may learn to harness as a source of renewable energy the hot air put out by the Congress.

It is hard to have a rational discussion with those who embody and express the views of a nation that is in denial. The US establishment and political class, and quite possibly much of its electorate, are indeed in denial, and not just about the need for an early traverse to a higher national saving rate. The economic, social and political model of the US has developed serious albeit remediable flaws and needs major surgery. Unfortunately none of those running for office today are likely to be willing or able to wield the scalpel as required.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.